- International Monetary Fund. Monetary and Capital Markets Department
- Published Date:
- October 2014
Capital Flows: Dynamics, Evolution, and Policy Advice
In an increasingly integrated world, capital flow volatility is a fact of life: the volume as well as the nature and destination of flows have evolved, as advanced, emerging market, and developing economies have responded to changes in their internal and external economic environments. Flows that are not related to foreign direct investment (FDI) can be especially volatile–a burst of foreign financial investment for a few quarters or even more can be followed by sudden disinvestment. This has been particularly burdensome for emerging market and developing economies over the past three decades.26 The rise in worldwide demand has nurtured the deepening of the domestic financial sector in these economies, producing stronger and more transparent financial institutions, cheaper and more varied sources of credit, and larger financial markets with more types of financial assets. Emerging markets’ relatively high growth rates and the deepening of their financial sectors have stoked foreign investment inflows, especially as investors seek to escape the low interest rates in advanced economies.
Any country with even a partially liberalized financial account is subject to a certain degree of capital flow volatility. However, large inflows and their sudden stop or reversal present a number of specific macroeconomic and financial stability concerns. The tapering of unconventional expansionary monetary policies in the advanced economies foreshadows such a reversal of capital flows, as was evident from the markets’ immediate reaction to announcements by the Federal Reserve in May 2013 about its plans to exit from quantitative easing. The subsequent behavior of the global markets can be divided into three phases. In phase 1, during May and June 2013, there was exchange rate depreciation, with increases in interest rates and sovereign credit default swap spreads that were similar across emerging market economies. In phase 2, during the second half of 2013, country-specific conditions played an important role in determining investors’ behavior. In phase 3, from the beginning of 2014, the importance of idiosyncratic country factors became even more pronounced, with concerns over political and economic vulnerabilities triggering country-specific movements in exchange rates and asset prices (IMF 2014a).
To understand the dynamics of capital flows, this Special Topic briefly traces their evolution over the past 30 years, describes their causes and effects, and summarizes the IMF’s findings on the appropriate policy packages to successfully deal with the inherent volatility of capital flows.
Recent History of Capital Flows: Volatile and Episodic
The rising magnitude and volatility of capital flows (Figure 2) present macroeconomic policy challenges and international financial stability concerns (IMF 2013b). When capital flows into small and shallow financial markets, asset prices increase, which improves national fiscal indicators and spurs domestic credit growth. Foreign direct investment (FDI), for example, has contributed to economic growth, productivity improvements, technological modernization, and human capital development in emerging market and developing economies (Arbatli 2011). But such favorable developments have sometimes aggravated structural weaknesses in these economies’ monetary and fiscal sectors (Reinhart and Reinhart 2008). FDI, especially greenfield FDI, is a relatively stable type of flow that is unlikely to carry major risks. Portfolio inflows, which can be large and volatile, carry greater potential risks for emerging market economies (IMF 2011; Chamon and others 2010).
Figure 2.Gross Capital Inflows for All Emerging Market Economies, 1990–2012
Sources: IMF, Balance of Payments Statistics; IMF (2013b); and IMF staff calculations.
In the late 1970s, heavy borrowing by emerging market and developing economies of short-term bank liabilities in foreign currencies created precarious currency mismatches. The continued heavy reliance on unstable short-term flows played a major role in the Latin American debt crisis of 1982, as well as in other financial crises in the 1980s and 1990s (CGFS 2009). For almost a decade, most capital moved only between advanced economies, until flows to emerging market and developing economies revived in the early 1990s.
By 1993, net flows to emerging market and developing economies had risen to about $150 billion from a 1983–90 annual average of less than $40 billion (Turner 1995). Declines in policy rates in the United States and Europe helped increase the supply of low-cost financing that flowed to Asian emerging market economies, which in turn increased their issuance of debt securities, denominated mostly in dollars. The capital flow surges were largely short term in nature and created a double mismatch of currency and maturities (ADBI 2010). These developments led to risky financing of large current account deficits, inflation, asset market bubbles, speculative activities (CGFS 2009), excessive credit growth, and currency appreciation.
The risks materialized in the 1997–98 Asian financial crisis, when inflows stopped and exposed the buildup of vulnerabilities (IMF 2013b). The fallout for many East Asian countries included large capital outflows, currency crises, the bursting of asset price bubbles, a collapse of investment, and banking and macroeconomic crises (CGFS 2009). Emerging market and developing economies in Latin America and Europe became more attractive investment destinations, but the flows remained uneven in the early 2000s, reflecting a reduced risk appetite. Starting in 2002, there was a continuous strong increase in gross and net flows among advanced economies and from advanced economies to emerging market economies, the latter of which increased by almost 600 percent over the next five years (IMF 2006).
There was a sudden stop of capital flows at the nadir of the global financial crisis in late 2008. A new surge arose in late 2009 and 2010, largely because advanced economies reduced their monetary policy rates to near zero in their efforts to recover from the Great Recession (IMF 2013b; CGFS 2009). Another outflow-inflow cycle occurred in late 2011–12, but gross capital inflows to emerging market and developing economies have declined since mid-2013. These declines have led to tightened financial conditions in these economies, creating a host of macroeconomic and financial stability risks. Countries with strong fundamentals and sound policies, however, have been able to withstand the impact of this volatility (IMF 2014b).
The Evolving Nature of Capital Flows
The nature of capital flows has evolved over time. There have been significant changes not only in their destination, but also in their composition, size, duration, volatility, and synchronicity.
Destination: During the early 1980s, capital inflows went mainly to Latin America and Asia. After the Latin American debt crisis, Asia became the most desirable destination, until the Asian crisis of the late 1990s. During the early 2000s, inflows spread to countries in emerging Europe and the Commonwealth of Independent States as more countries joined the European Union and as investors looked for new investment opportunities. However, in the wave that occurred after the beginning of the global financial crisis, countries in emerging Europe did not experience the inflow surge that their non-European counterparts did. Moreover, the sudden stop of capital flows in the wake of the crisis turned into capital flight from the periphery to the core of the euro area (Figure 3). The global financial crisis also brought about a collapse of gross flows (mostly bank flows) among advanced economies and a concomitant increase in flows to emerging market and developing economies (IMF 2011, 2012a).
Figure 3.Portfolio and Other Investment Capital Flows in the Euro Area
Sources: Haver Analytics; IMF (2012a); and IMF staff estimates.
Note: Core = Belgium, France, Germany, Netherlands; Periphery = Greece, Ireland, Italy, Portugal, Spain.
Composition: FDI–dominated inflows to emerging market and developing economies during the wave of the mid-1990s, but bank lending has more than doubled since, and there has been a significant increase in portfolio flows (purchases of financial assets–another form of financing), both in absolute terms and relative to GDP. The average pace of portfolio inflows during the 2009 postcrisis wave quadrupled, from about 0.3 percent of GDP to 1.2 percent, and accounted for about half of total flows (IMF 2011). In response to prolonged low interest rates in advanced economies, investors (including insurance companies and pension funds) increased their demand for higher-yield emerging market assets. But slower growth in the supply of such assets contributed to a further shift in the composition of flows, specifically by increasing the share of sovereign bond holdings by nonresidents (IMF 2013a).
On the corporate side, the issuance of bonds has grown relative to that of equities, leading to higher debt-to-equity ratios in emerging market and developing economies and, in some cases, to a higher share of liabilities denominated in foreign currencies, the level of which has increased by about 50 percent in the past five years (IMF 2013a). The shift from FDI to less stable portfolio flows, including those denominated in foreign currencies, has contributed to making flows more sensitive to global shocks. In response, many emerging market and developing economies have taken steps to limit their vulnerability by deepening their banking sectors and capital markets, making institutional improvements, and recruiting local investors (IMF 2014a).
Size and duration: Capital flow “bonanzas”–strong inflows that are larger than normal–have become more frequent with the decrease of restrictions on capital flows (Reinhart and Reinhart 2008; Eichengreen and Adalet 2005). The surges that occurred just before the global financial crisis were larger and longer than those that occurred before the Asian crisis (IMF 2013b). A typical episode lasted about 13 quarters in the 1990s and about 20 quarters in the 2000s; the average size of aggregate inflows rose from slightly less than 2 percent of GDP a quarter in the 1990s to about 3.3 percent of GDP a quarter in the 2000s (IMF 2011).
Volatility: Non-FDI flows tend to be more sensitive to changing macroeconomic and financial conditions than FDI flows. Portfolio inflows have historically been more volatile than other types of inflows, and they have recently become even more so. At the same time, the volatility of bank lending flows rises significantly during crises given their highly procyclical character. For example, credit demand rises when economic growth increases and perceived risks decrease, but as retail deposits become insufficient to fund the demand, cross-border bank lending (so-called non-core funding) and leverage ratios both rise. During economic downturns, the opposite occurs: bank lending decreases sharply as funding constraints and credit risks escalate (IMF 2011; Committee on International Economic Policy Reform 2012).
On the whole, the volatility of capital flows has increased over time. Bluedorn and others (2013) conclude that this increased volatility has been quantitative rather than qualitative in nature–that is, the volatility is a result only of the expanded volume, not of a change in the incremental volatility of net or gross flows relative to GDP. However, they note that these measures may mask qualitative differences. The volatility of total net flows for advanced economies and for emerging market and developing economies was found to be similar despite the higher volatility of the various components of capital flows in advanced economies. The authors suggest that a possible explanation could be greater substitutability between different types of flows, as well as the complementarity of inflows and outflows in advanced economies compared with flows to emerging market or developing economies.
Synchronicity: Inflow episodes often end simultaneously in a number of countries, given that all countries are subject to the same global conditions and also to contagion (Calvo, Izquierdo, and Mejia 2004). In contrast, the beginning of episodes is generally not simultaneous across countries because idiosyncratic country factors attract capital inflows at different times. However, external conditions have recently influenced not only the ending of inflow episodes but also their beginning (IMF 2011): during the second half of 2009, 18 emerging market and developing economies experienced large inflows simultaneously as the advanced economies started their unprecedented monetary easing.
Countries’ Resilience to Capital Flows
Resilience refers to the ability of an economy to sustain longer and stronger expansions and to experience shorter and shallower downturns and more rapid recoveries (IMF 2012c). In general, the countries that enjoyed greater resilience were those with better prudential regulations and financial supervision, more countercyclical fiscal and monetary policies, more flexible exchange rate regimes, and more stable current accounts (net capital flows).
Chamon and others (2010) find that some controls on capital flows (in particular debt flows) may contribute to limiting financial fragility in the face of capital flow volatility. However, a decision to implement controls should also take into account the potentially adverse multilateral consequences of such controls.
The increasing role of domestic institutional investors in emerging market and developing economies may have helped counteract the strong external drivers of capital inflows. For example, many of these countries have introduced pension systems that supplement or replace state-provided plans with partially or fully funded defined-contribution plans. Many have also reduced or eliminated limits on investments by institutional investors, broadening the permissible scope of asset types and asset locations. The accumulation of private sector wealth and improvements in financial literacy have further boosted domestic investment. These developments have stimulated the creation of various collective investment vehicles such as mutual funds and unit trusts. In addition to the other benefits associated with diversification, outflows through such institutional investors can help offset some of the effects of large capital inflows (CGFS 2009).
Counterbalancing capital flows may have also enhanced resilience in some countries facing capital outflows. During the global financial crisis, emerging market and developing economies reacted in a remarkably different way than during previous crises: when nonresident inflows stopped, residents in many cases repatriated their own foreign-held assets, providing a buffer that contributed greatly to the resilience of those economies and minimized the disruption from nonresident outflows. Such repatriation enabled most of the adjustment to occur in the financial sector, in contrast to previous sudden stops, when most of the adjustment took place in the real sector, lowering GDP and consumption and raising unemployment. It should be noted, however, that such a mechanism may not always be at work: domestic vulnerabilities or global shocks may encourage residents to move their investments to safe havens (Broner and others 2013; IMF 2013b).
Drivers of Capital Flows
The timing, magnitude, and duration of capital flows has been the subject of academic and policy debates since at least the mid-1930s, when the United States experienced a surge in capital inflows (Qureshi 2012). Two concepts have figured prominently in the analysis: the investment behavior of residents and foreigners, and domestic versus external economic conditions.
Domestic versus foreign investors: Domestic investors and foreign investors may differ in the way they respond to internal and external conditions and to shocks. If simultaneous, these responses could offset or magnify each other (Forbes and Warnock 2012b). Ghosh and others (2014), for example, find that foreign and domestic investors respond similarly to domestic conditions, but that foreign investors react more to changes in global conditions (such as U.S. interest rates and global market uncertainty). The determinants of surges of domestic outflows were found to be idiosyncratic and difficult to generalize.
Incentives (such as the domestic exchange rate) and constraints (such as access to liquidity) differ by country for domestic and foreign investors. Gross flows are determined by foreigners’ investments in a given country and residents’ investments outside of that country. However, resident outflows in emerging market economies are usually not sufficient to offset foreign inflows. Thus, net flows for emerging market economies seem to be largely driven by foreign investors (Bluedorn and others 2013). Asymmetric information may provide a timing advantage to domestic investors with regard to positive and negative shocks to domestic assets (Tille and van Wincoop 2012). In a crisis, a default is more likely to hit foreign than domestic investors, which might trigger a transfer of assets from foreign to domestic investors (Broner, Martin, and Ventura 2010).
Domestic (pull, or demand-side) factors include improved macroeconomic fundamentals, higher institutional quality, lower risk, favorable regulations and policies, and market idiosyncrasies (Qureshi 2012). Local factors, such as current account deficits and real GDP growth, have been found to be correlated with net capital surges (Reinhart and Reinhart 2008; Cardarelli, Elekdag, and Kose 2009). However, in recent years their influence appears to have been less than that of global external conditions (Ghosh and others 2014; Broto, Diaz-Cassou, and Erce 2011). Qureshi (2012) observes that one demonstration of the force of external factors was the reversal of flows to emerging market economies that occurred when global risk aversion (measured by the Chicago Board Options Exchange Volatility Index [VIX]) increased following Standard & Poor’s downgrade of the United States’ sovereign debt rating from AAA to AA+ in August 2011.
External (push, or supply-side) factors include low interest rates and GDP growth in advanced economies, higher risk appetite and higher commodity prices, liquidity, contagion through financial linkages, trade flows, and geographic proximity (Reinhart and Reinhart 2008; Cardarelli, Elekdag, and Kose 2009; Mercado and Park 2011; Forbes and Warnock 2012a). When interest rates in advanced economies are relatively low and investor risk appetite is high, the occurrence of capital flow surges is likely to increase, and vice versa.
In an illustration of the interaction between push and pull factors, Ghosh and others (2014) find that, although surges in net capital flows tend to cluster in time, the volume of these surges tends to vary considerably across countries, as does the set of emerging market economies that experience any given surge. The synchronicity is explained by global (push) factors (U.S. interest rates and risk aversion), but pull factors–including economic growth, external financing need, capital account restrictiveness, exchange rate regime, and institutional quality–determine the characteristics of the surge as experienced by a given country.
Sudden Stops: Determinants and Effects
Sudden stops in capital flows may lead to excessive exchange rate depreciation, credit busts, and asset price deflation, and thus may destabilize the domestic economy. As early as 2004, the observed clustering of sudden stops across countries highlighted the importance of assessing individual countries’ vulnerability to external shocks (Calvo, Izquierdo, and Mejia 2004; Magud and Vesperoni 2014).
There are two types of sudden stop: inflow driven, when foreign investors sharply reduce, discontinue, or withdraw their investments; and outflow driven, when residents invest heavily abroad. Both may be preceded by a surge of capital inflows, although not necessarily (Magud and Vesperoni 2014). Calderón and Kubota (2011) find that inflow-driven stops tend to be most clustered in time but that outflow-driven stops, which are generally more spread out over time, have recently become more frequent. The type of stop also influences the subsequent state of the domestic economy: an inflow-driven stop tends to lead to lower growth than would an outflow-driven stop, including lower gross domestic investment, lower GDP per worker, and lower total factor productivity.
External factors, such as increased investor risk aversion, higher global growth, and higher interest rates in the advanced economies, increase the probability of sudden stops (Forbes and Warnock 2012a). The effect of these global factors may be amplified by the state of the domestic economy. Inflow-driven sudden stops are more likely when economic growth rates are low and the export base is volatile (as proxied by an abundance of natural resource exports). The likelihood of such stops decreases when the domestic economy is growing and the world interest rate is lower than the domestic rate. The factors that predict outflow-driven sudden stops are financial openness and external savings (current account surpluses) (Calderón and Kubota 2011).
Analyzing data from 32 advanced economies, Calvo, Izquierdo, and Mejia (2004) find that openness27 and domestic liability dollarization are the main contributors to the increased probability of sudden stops. Openness is determined by domestic policies, such as tariffs, that influence the supply of tradable goods; and dollarization is a product of fiscal and monetary policies.
Sudden stops in gross flows do not necessarily result in sudden stops of net flows, but they can still have significant effects. Sudden stops in gross flows that arise from changes in international banking flows are associated with potentially destabilizing deleveraging within a short time.
Using data for a sample of 63 advanced, emerging market, and developing economies for the period 1980–2012, Cavallo and others (2013) create a new taxonomy of sudden stops, which they classify into seven categories that represent all possible mixes of origins of changes in flows that together constitute a sudden stop: changes in gross capital inflows, outflows, and net capital flows (Figure 4 and Table 12).
Figure 4.A Taxonomy of Capital Flow Sudden Stops
Source: Cavallo and others (2013).
Note: SSI = sudden stops in gross inflows; SSIN = sudden stops in gross and net inflows; SSION = sudden stops in gross and net inflows plus sudden starts in gross outflows; SSO = sudden starts in gross outflows; SSON = sudden starts in gross outflows and sudden stops in net flows; SSN = sudden stops in net flows; SSIO = an empty set because all cases of concurrent SSI and SSO are included in SSION.
|Type of Event||All Countries||Advanced Economies||Developing Economies|
|Before 2000||After 2000||Before 2000||After 2000|
Cavallo and others (2013) find that sudden stops in gross inflows have a greater negative effect than sudden surges in gross outflows, which were not found to be followed by decreases in real GDP. A sudden stop in net flows originating from a sharp decrease in bank flows was found to have the greatest negative impact. Sudden stops in net flows are often followed by real currency depreciations and current account adjustments, which in turn lead to lower economic growth or recessions. This study also emphasizes that advanced economies are not immune to experiencing sudden stops.
The Composition of Large Flows and the Probability of Crisis
Several studies have found that capital inflow bonanzas significantly increase the probability of banking and currency crises and, most significantly, of balance of payments crises once the surge ends (Reinhart and Reinhart 2008; Furceri, Guichard, and Rusticelli 2011). They often include a proportional comovement in the cumulative capital inflow and the probability of a sudden stop. In addition, the post-sudden-stop levels of capital inflows in about one-fourth of the capital flow episodes were found to be significantly lower than the prebonanza levels (Furceri, Guichard, and Rusticelli 2011; Forbes and Warnock 2012a).
The composition of the flows in a given episode has a large bearing on the probability of those crises: debt-driven flows significantly increase their likelihood, while equity-driven flows (portfolio flows as well as FDI) have a negligible effect. Furceri, Guichard, and Rusticelli (2011) find a near doubling of the probability of a banking or a currency crisis two years after a sudden stop of large capital inflows.28 They also find the following factors to be significant for the various types of crisis: inflation and short-term interest rates for banking, currency, and balance of payments crises; foreign reserves for banking and currency crises; bank concentration for banking crises; and size of country, trade openness, net foreign asset position, and foreign debt for balance of payments crises. However, they conclude that while countries may not have much power to prevent a sudden stop, their institutional quality and regulatory framework greatly influence the likelihood of experiencing banking and currency crises.29 Glick, Guo, and Hutchison (2006) find that an increase in capital account openness and financial liberalization also reduces the probability of banking and currency crises.
Role of Exchange Rate Flexibility
Exchange rate flexibility cannot prevent a sudden stop or reversal, but it can decrease the effect of inflow-driven credit booms (Elekdag and Wu 2011). Several studies examine the relationship between exchange rate flexibility and the behavior of credit in the banking sector during capital flow bonanzas. Magud, Reinhart, and Vesperoni (2012) and Magud and Vesperoni (2014) find that bank credit, especially credit denominated in foreign currency, grew more rapidly in countries with less flexible exchange rate regimes. Furceri, Guichard, and Rusticelli (2011) also find that credit expansions from large inflows were smaller in countries with higher real exchange rate flexibility.
Lane (2013) focuses on Europe and finds similar results. As exchange rates tend to depreciate during crises, the foreign currency value of domestic assets decreases, which may attract new capital inflows and partly offset the outflows. This mechanism is not available, however, to countries that do not have their own currency, as in the euro area. Overall, the likelihood of crises is reduced even when the exchange rate is less than fully flexible, such as under floating and managed float regimes.
Ghosh, Ostry, and Qureshi (2014) find that countries with hard pegs were not particularly susceptible to banking or currency crises owing to official actions to maintain such regimes, but they were significantly more susceptible to growth crises than countries with floating rate regimes. Intermediate regimes appear to be more prone to banking and currency crises, but managed floats–a subclass within such regimes–behave much more like pure floats, with significantly lower risks and fewer crises. Given the resilience of countries with managed float regimes, however, the susceptibility to crises was related to central bank actions–whether the central bank intervened to limit overvaluation or whether it abstained from intervention to maintain an overvalued exchange rate.
How can policymakers mitigate the effects of large capital inflows and their reversal? According to the IMF’s institutional view on the liberalization and management of capital flows (IMF 2012b), the appropriate policy responses comprise a range of measures and involve both countries that are recipients of capital flows and those from which flows originate. For countries that have to manage the macroeconomic and financial stability risks associated with inflow surges or disruptive outflows, a key role needs to be played by macroeconomic policies, including monetary, fiscal, and exchange rate management, as well as by sound financial supervision and regulation and strong institutions.
The appropriate combination of policies for addressing these risks would depend on country circumstances. In certain circumstances, capital flow management measures (CFMs) that are designed to limit capital flows can be useful. They should not, however, substitute for warranted macroeconomic adjustment. When capital flows contribute to systemic financial risks, CFMs in combination with macroprudential measures (MPMs) more broadly can help safeguard financial stability, although their costs also need to be taken into account.30
The choice of which CFM to use would depend on its expected effectiveness and efficiency. The design and implementation of CFMs should be transparent, targeted, temporary, and preferably nondiscriminatory.
In general, policy options for managing inflow surges depend upon country-specific factors, which determine which options are feasible and effective. Outflows should usually be handled primarily with macroeconomic, structural, and financial policies. In crisis situations, or when a crisis may be imminent, there could be a role for the introduction of temporary CFMs on outflows.
Policymakers in all countries, including countries that generate large capital flows, should take into account how their policies may affect global economic and financial stability. Cross-border policy coordination among recipient countries, and between source and recipient countries, would help mitigate undesired spillover effects of policies and achieve globally efficient outcomes.
Capital flows are volatile and are continuously evolving in response to a wide range of factors, including macroeconomic conditions, economic development, regulatory frameworks, the business cycle, saving patterns, and investor expectations. But available knowledge, tools, and practical experience can help economic policymakers mitigate and recover from their disruptive effects. To be effective, however, any policy response requires an accurate understanding of the causes and effects of flow volatility and supportive macroeconomic and regulatory policy frameworks. Further research on the evolving nature of capital flows can help improve the effectiveness of the tools for mitigating their risks without negating their financial and developmental benefits.
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